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The Federal Reserve Should Raise Rates Immediately

To help the economy, the Federal Reserve should begin raising
rates immediately and bring its preferred policy rate, the federal
funds, to a more neutral stance. The Fed’s current rate policies
have not delivered economic growth or employment and should be
abandoned in favor of policies that would.

The theory behind the Fed’s current rate policy is that lower
rates increase the demand for borrowing, which should fuel both
credit-driven spending and investment. This however, only examines
one side of the market: demand. For credit to expand, lenders must
be willing to lend at those rates as well, but current rates barely
cover a lender’s inflation risk without also covering the risk of
not being repaid.

It was a housing boom and bust that contributed primarily to the
recession and financial crisis. While housing prices have begun to
recover, credit for less-than-prime borrowers is still limited,
leaving about a fifth of the market on the sidelines.

Interest rates should be
determined by the interaction of savers and investors, not driven
by the arbitrary whims of government officials in
Washington.

Looking at mortgage rates offers some explanation. Today,
30-year fixed rates are just over 4.2 percent. With inflation
expectations running around 3 percent, that leaves the lender only
1 percent to cover credit losses and any profits. With just over 2
percent of prime mortgages still in foreclosure, and assuming a 50
percent recovery rate, it becomes obvious that anything but
sterling credit is expected to be a money loser for banks.

So why don’t banks just charge more? Because so-called consumer
protection laws would kick those mortgages into the “high cost”
category, which brings considerable legal risk. Letting rates rise
would greatly increase the supply of mortgage credit, helping to
fuel home sales and eventually home construction.

Low rates are often defended as “putting money in the consumers’
pocket” but that couldn’t be further from the truth. It simply
transfers money from one set of consumers to another. The
approximately $400 billion annual decline in consumer interest
payments since 2008 has been exactly off-set by the approximately
$400 billion annual decline in household interest income. Lower
rates simply benefit one set of households at the expense of
another. The net impact on spending will likely approximate
zero.

There is also little evidence that the Fed’s current rate
policies have improved the labor market. Advocates of the Fed’s
current policies often claim that a lack of “demand” is holding
back the job market. Yet consumer spending has steadily increased
since 2009 and growth in the labor market has not kept up with that
increased demand. This suggests that the problem is not a lack of
demand, but rather problems specific to the labor market, which are
beyond the control of the Federal Reserve.

Our economy is facing a number of problems today. Too high
interest rates are not one of them. If anything, the Fed’s policies
of channeling credit away from the private sector and towards the
federal government (and its mortgage agencies) has denied badly
needed credit to the more productive elements of our economy.
Ultimately, interest rates should be determined by the interaction
of savers and investors, not driven by the arbitrary whims of
government officials in Washington.